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Text 2 Corporate Finance
Firms need short-term, intermediate-term and long-term finance. The two main choices for long-term finance are debt or equity finance. Debt finance can be raised in two main ways: long-term loans from banks and bonds (also known as loan stock or corporate bonds). Bonds are also called debentures in Great Britain.
Equity finance is sale of shares. Which method of long-term finance should a company choose? There is no easy answer to this question. Some businesses will use both debt and equity finance for very large projects.
Debt financing has the following advantages:
- As no shares are sold, the ownership of the company does not change or is not «diluted» by the issue of additional shares.
- Loans will be repaid eventually, so there is no permanent increase in the liabilities of the business.
- Lenders have no voting rights at the annual general meetings.
- Interest charges are an expense of the business and are paid out before corporation tax is deducted, while dividends on shares have to be paid from profits after tax.
- The leverage of the company increases and this gives common shareholders the chance of higher returns in the future.
Equity capital has the following advantages:
- It never has to be repaid; it is permanent capital.
Dividends do not have to be paid every year; in contrast, interest on loans must be paid when demanded by the lender.
Assignments to text 3:
1. Read the text and say what types of securities are compared.
2. Find definitions of different securities.
3. Look through the text and find the sentences explaining advantages and disadvantages of being a bondholder/ stockholder.
4. Translate the text.
Text 3 Types of Securities
A company wishing to raise funds will issue or sell not only common stock but also preferred stock and bonds (debentures). There is a certain difference between these 3 types.
Common stock is shares of ownership in a corporation. As owners of the firm, common stockholders stand to make good profits when the firm is successful, but will sustain losses when business is poor.
Common stockholders are often named the residual owners. They are so named because they have the right to residual earnings of the corporation. If a corporation were to go bankrupt, the common stockholders would be the last to receive any proceeds from the sale of the corporation’s property. This is because all other creditors, bondholders, and preferred stockholders must be paid first. What is left is considered residual earnings. Common stockholders are paid out of these residual earnings if dividends are declared by the board of directors.
Some investors prefer to give up the chance of a higher return in exchange for greater security in the event of low earnings or losses. One way to tap capital held by such people is to offer them preferred stock (or preferential-British English).
Preferred stock is, like common stock, a share in the ownership of the company but instead of equal participation in the profits, preferred shares carry fixed annual dividends that must be paid before dividends can be declared on a common stock. There are many different types of preferred stock but most are cumulative. That is, if the fixed preferred dividends are not paid in a given year, they accumulate, and all arrears must be paid before any dividends can be declared on common stock.
In exchange for this preferred dividend position, preferred stockholders give up the chance of participating in management. Nevertheless, they are still owners. They have no claim on the firm, in the event of liquidation they must wait, like other owners, until all creditors are paid off. If any ownership equity remains after the creditors are paid, the preferred stockholders are entitled to recover their equity before the common stockholders.
Bonds/Debentures. Lending to companies is often in the forms of bonds or debentures, loans with special conditions. One condition is that the borrower must have collateral or security: that is, if the borrower can not repay the loan, the lender can take equipment or property, and sell it in order to get the money back. This may be an asset which was bought with the loan. Some corporations borrow money for long periods by issuing bonds. Bonds are corporate IOYs that promise to pay a specified annual rate of interest and to repay the borrowed principal (a sum of money) on a specified date.
Bond interest and principal are contractual claims against the firm and must be paid whether the firm makes profit or not. If payments are not made on time, the bondholders can sue the firm to collect.
The use of bonds makes it possible for a firm to borrow large amounts of money from a number of small creditors on a long-term basis. Instead of a series of bonds for a number of separate debts, a company may create one fund of bonds and issue certificates for particular divisions of the fund. In simpler words, it breaks up the debt into small units, just as issuing stock breaks up the ownership equity. Certain kinds of firms, most notably public utilities, raise more of their capital by bonds than by stocks.
In many ways, a bondholder is as much an investor as a shareholder. But a shareholder is a member of the company whereas a bondholder is a creditor, whatever the similarities or dissimilarities between the rights and obligations of the two.
Whereas the articles of association can be varied, the rights of bondholders are fixed by the contract of loan and any attempted variation of them by the company (other than under a compromise or arrangement) will be a breach of contract.
The law governing the transfer of the securities held by shareholders and bondholders is basically similar, apart from the fact that bonds must be transferred as a whole (therefore there is no need to certify transfers of them) and are generally transferable without limitation. In other respects, the law differs.
Assignment to text 4:
1. Read the text and write down all the key terms.
2. Answer the following questions:
· What is a dividend?
· What is retained earnings?
· What can the shareholders benefit from?
Text 4 Share capital. Transferability
Share capital may be nominal capital, i.e. the amount of money which a company’s memorandum entitles the company to raise. This may comprise issued share capital (the shares actually issued) and unissued share capital. Paid up capital represents the money actually received from share issued and uncalled capital the amount still owed. Reserve capital is uncalled capital which the company has resolved only to call up on liquidation. Most shares today are fully paid up and often worth more than their nominal value.
The profits from the operations of the firm accrue to the equity of the stockholders, and are distributed by the board of directors. The board decides how much of the profit is to be paid out to shareholders as dividends. A cash dividend is a cash payment to shareholders. A stock dividend is a payment to shareholders of additional shares of stock rather than cash. The remainder of the profits constitutes retained earnings and is reinvested in the firm, thereby increasing the stockholders equity.
The shareholders benefit from becoming a member of a limited liability company. A share is normally transferable, and individual shareholders can transfer their shares of corporate ownership merely by selling their stock to somebody else. Organized stock exchanges permit the transfer of the stocks of many corporations in a matter of hours. This easy transferability permits many investors to participate in corporate ownership. The stockholders benefit from being able to trade with their liability limited to the value of their shares and they may be able to obtain tax advantages from investing in this form of business. For persons who merely wish to invest in, rather than to participate in the running of, a business enterprise, it is convenient to put their money into a company, the day-to-day activities of which can be carried on by an appointed board of directors.
Assignment to text 5:
1. Read and translate the title.
2. Read the text and find the sentences which would help to give a definition of “leverage”.
3. Look through the text paying attention to all figures. What is their function?
4. Translate the text.
Text 5 Leverage
When part of a firm's capital is raised through preferred stocks and bonds, fluctuations in total earnings have a magnified effect on the income of common stockholders. This phenomenon called leverage arises because preferred stocks and bonds are fixed income securities. Leverage is best illustrated by example. Suppose a corporation's ownership equity of $10 million consists entirely of 100,000 shares of common stock. Since they are not fixed income securities, earnings per common share vary exactly in proportion to total earnings. Total earnings of $500,000 would be $5 per share. If total earnings doubled to $1 million, earnings per common share would likewise double to $10. If earnings shrank 80 percent from $500,000 to 100,000, earnings per common share would likewise decline 80 percent from $5 to $1.
Now suppose, however, the same corporate ownership consists of 5 million of 5 percent preferred stock and $5,000,000 divided into 50,000 shares of common stock. Regardless of total earnings, the preferred stock is entitled to dividends of $0,05 × 5 million or $ 250,000. This fixed income gives leverage to the common stock. Thus, when total earnings are $500,000, preferred stockholders receive $250,000, leaving $250,000, or $5 per share of common stock, just as before. But when total earnings double to $1,000,000, the leverage provided by the fixed income securities triples the earnings per common stock share. Preferred stockholders still get only their $250,000, leaving earnings of $750,000, or $15 per share, to the common stock. Unfortunately, leverage also works when earnings decline. Should total earnings fall to $100,000, preferred stockholders would still be entitled to their fixed $250,000. This would leave common stockholders a loss of $ 150,000, or $3 per share, despite the positive total earnings made by the company.
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